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A New Vanguard Index Fund Could Lag Active Managers

NEW YORK ( TheStreet ) -- Among the most popular mutual funds last year was Vanguard Total International Bond Index (VTIBX). Launched in June, the index fund now has $18.9 billion in assets. The inflows were particularly notable at a time when many shareholders abandoned bond funds. During the first 11 months of 2013, investors withdrew $73 billion from intermediate-term funds, according to Morningstar.

With its low expense ratio of 0.23%, the Vanguard fund clearly has appeal. If U.S. bonds sink this year, foreign fixed-income markets could offer diversification. But many investors may prefer actively managed global funds instead of the passive Vanguard choice. In the past, active funds have outdone the benchmarks.

During the past five years, the average world bond mutual fund returned 7.3% annually, surpassing the Barclays Capital U.S. Aggregate Bond Index by two percentage points and topping the Citigroup Non-U.S. dollar World Government Bond Index by 3.2 percentage points.

A recent Vanguard study concedes that the returns of many active managers have beaten the benchmarks. The researchers looked at how 275 global bond funds performed during the 10 years ending in 2012. In that decade, 57% of the funds topped the unhedged Barclays Global Aggregate Bond Index.

Why have the active managers excelled? Vanguard says the portfolio managers have increased returns by taking on risk. While the global benchmarks are heavy with high-quality government issues, the active managers sometimes buy low-quality bonds and securities from shaky emerging markets. The strategy has boosted returns in good times, but the riskier approach has sometimes fared poorly in downturns. During the turmoil of 2008, world mutual funds lagged the Barclays U.S. Aggregate by 6.8 percentage points.

The Vanguard index fund could be particularly well-suited for conservative investors because the portfolio focuses on investment-grade bonds in developed markets. In addition, the fund hedges away currency risk.